The European Central Bank has issued Cyprus with a stark ultimatum: either it reaches a bailout agreement with the European Union and the International Monetary Fund by Monday, or country’s troubled banks will lose access to emergency funding.

In a short statement the ECB said its 23-member board had decided to maintain emergency liquidity provision – the low cost loans that are keeping the country’s two largest banks afloat – until Monday. After that, it will only continue to provide the funding if a bailout program is in place that would ensure that the banks are solvent.

The country’s two largest banks, the Bank of Cyprus and Laiki, are close to insolvent and rely heavily on emergency liquidity provided by the central bank of Cyprus because they have run out of enough acceptable collateral to qualify for regular ECB funding. Without this emergency funding central bank money, the country’s financial sector would likely collapse, which could force Cyprus to quit the euro zone.

Jeroen Dijsselbloem, who heads the group of euro zone finance ministers conceded overnight that Cyprus now represented “a systemic risk" to the euro zone, while the Bank Cyprus issued a statement urging the country’s political leaders to reach a bailout deal to save the economy from ruin. “The Cyprus economy is on the brink and in a fragile state. The next move may prove its salvation or destruction", it said. Cypriot banks will remain closed until next week because of fears they will face massive withdrawals when they open.

The ECB’s hardline position – the first time the bank has publicly threatened to cut off a country’s banks from emergency funding - sets a clear deadline for Cypriot lawmakers who on Tuesday night rejected a bailout plan that would have taxed the deposits of account holders in the country’s banks.

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Cypriot authorities are continuing to examine alternative proposals– including possible financial assistance from Russia or tapping the country’s pension funds – for raising the €5.8 billion ($7.5 billion) that the tax on bank accounts was supposed to bring in as part of the country’s €10 billion bailout. But European leaders are also insisting that Cyprus should shrink its bloated banking sector – whose assets stand at a massive eight times the country’s GDP.

Wary of the Russians

“The banking sector should make a contribution to make debt sustainable", German Chancellor Angela Merkel said on Wednesday. French president François Hollande, repeated the message in a telephone conversation he held with Cyprus’s president Nicos Anastasiades.

But Anastasiades, who is wary of upsetting the Russians who account for around 30 per cent of the deposits in Cypriot banks, appears to have dropped the idea of taxing bank deposits. Instead Cypriot political leaders have agreed to set up a “investment solidarity fund" that would bundle together state assets to enable an emergency bond issue to raise the €5.8 billion demanded by the EU and the IMF. According to the parliamentary speaker, Yiannakis Omirou, the subject of a levy on bank deposits was not on the table.

The Cypriot government is also looking at restructuring the country’s two largest banks, and hiving their problem loans into a separate “bad bank", and possibly combining the two lenders. In a sorry end for the island, which previously dreamt of transforming itself into the Switzerland of the Mediterranean, the average doubtful debt levels of the Cypriot banks stands at an alarming 26.5 per cent.